Deere Has Rocky Hills to Climb

The challenge for Deere (DE) isn’t revenue growth. Revenue grew by 24% in the fiscal third quarter, the company announced August 17.

Controlling costs is the issue. Operating income in the quarter rose by just 12.5%. Raw materials costs, the company said, will be $700 million higher in 2011 than in 2010. That’s a $100 million increase from the company’s forecast last quarter.

That didn’t stop Deere from raising its net income forecast for the full fiscal year to $2.7 billion, from the prior forecast of $2.65 billion. But that 1.9% increase in projected net income lagged the 2- to 4-percentage-point increase in the company’s revenue targets for all of fiscal 2011. (Deere’s fiscal year ends October 31.)

If Deere is a core position in your long-term portfolio, I don’t think you need to sell—the long-term trends toward higher global incomes and greater consumption of grains and grain-fed meat remain intact, and Deere is a major beneficiary of those trends. (Deere is a member of my long-term Jubak Picks 50 portfolio.)

But I wouldn’t make adding to positions here my No. 1 portfolio priority, either. The company’s agricultural-equipment business faces tough growth comparisons over the next few quarters, and the recent shift toward sales of less expensive, less powerful tractors and the like will make it even tougher to beat growth in past quarters.

In recent quarters, the construction-equipment unit has shown accelerating growth, and that will help pick up some of the slack from agricultural equipment sales. But the construction-equipment unit makes up only 14% of revenue.

The stock is cheap if you compare the current 10.5 price-to-earnings ratio on Standard & Poor’s projected fiscal 2012 earnings per share of $7.67 with the 13 multiple that the company has historically commanded near the middle of the upward trend in its business cycle.

But given the rising raw-materials costs, the tough comparisons in the agricultural equipment unit, and the uncertainties about global economic growth that the company flagged in its quarterly guidance, I’d be reluctant to assume the stock’s right to trade at a 13 multiple.

If instead you assigned the shares a 12 multiple on projected fiscal 2012 earnings, then the target price comes out at $92. That’s about 15% above the price at 2:15 p.m. New York time today. All of which argues that the shares are priced about right for current risk and reward.

In other words, I wouldn’t sell here, nor would I chase the stock. If, on the other hand, shares revisited anything like their $64.47 52-week low, I’d back up the truck for my long-term core portfolio.

Full disclosure: I don’t own shares of any stock mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Deere as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.